Japan inflation hits decade high, BOJ seen unmoved

By Leika Kihara

TOKYO (Reuters) - Japanese annual inflation hit a decade-high 1.0 percent in February, but the credit crisis and a stalling Japanese economy mean the Bank of Japan is still seen as more likely to cut interest rates this year than raise them.

Unemployment edged up in February while household spending was flat from a year earlier, data showed on Friday, prompting Economics Minister Hiroka Ota to renew her warning that the economy was stalling.

The Bank of Japan has been looking for a return to inflation in Japan after nearly a decade of deflation, but it was hoping for an improving economy to drive prices up, when instead they are being pushed up by rising oil and food costs.

"The Bank of Japan can't raise rates and I don't think its stance will change any time soon," said Tsuyoshi Segawa, an equity strategist at Shinko Securities.

The 1.0 percent rise in the core consumer price index, which included oil products but not some volatile fresh food prices, topped a consensus forecast for a 0.9 percent increase from a year earlier.

Despite the rise in inflation, many market participants expect the central bank to keep its key policy rate unchanged or even cut it from the current 0.5 percent this year on mounting fears that financial market turmoil and slowing U.S. growth could drag Japan's economy into a recession.

Investors are pricing in about a 20 percent chance of a rate cut by June and 50 percent by the end of the year MIRS6, although many economists do not see much chance of any rate move in the near term.

However, concern is building within the government, with Ota saying the higher inflation, and the rising gasoline and food prices behind it, was a problem for the economy.

"I am worried about its impact on consumer sentiment," Ota told a news conference after a cabinet meeting.

Markets were focused on other issues, with the Nikkei share average .N225 down half a percent and the yen JPY= little changed around 99.45 per dollar. .T <FRX/> FXNEWS

Economists, however, warn of problems if such cost-driven inflation is prolonged, saying it will hurt consumer consumption, which makes up roughly half of Japan's economy.

"Rising inflation deprives consumers of purchasing power when wage growth is limited, and that is what the BOJ will have to pay attention to," said Yoshimasa Maruyama, an economist at BNP Paribas.

Japan's seasonally adjusted unemployment rate rose to 3.9 percent in February from 3.8 percent in January, above a consensus market forecast of 3.8 percent.

Overall household spending was flat in February from a year earlier in price-adjusted real terms, lagging a median market forecast for a 2.4 percent increase. JPALLS=ECI

Japan's economy, driven by solid exports, grew 0.9 percent in the last three months of 2007, but economists warn this may be the last strong quarter for a while, with some saying the world's No.2 economy may already be in recession.